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Based on the often-scathing replies to my recent Twitter/X thread, many people seem skeptical of the Canada Pension Plan (CPP). I think it’s one of the best retirement assets that money can buy.
CPP is a social insurance plan designed to contribute to retirement incomes in Canada. Under new enhancements, CPP will eventually replace 33.33 per cent of pre-retirement income up to a maximum, improving the retirement income adequacy of Canadians.
The enhancements are funded by an increase in required CPP contributions, which will be fully implemented in 2025. In total it is estimated that the 2025 combined employee and employer CPP contribution will be $8,848.
The reasons for distaste about these sizable CPP contributions centre on people thinking they could do better with private savings and investments – but this perspective demonstrates a lack of understanding of what CPP provides.
The CPP benefit is an inflation-indexed annuity – the only true risk-free asset for a long-term investor.
This is an asset that hedges three of the most important risks that retirees face: longevity risk, inflation risk and sequence-of-returns risk. Inflation-indexed annuities are not available for sale privately in Canada.
Longevity risk
The risk of depleting a portfolio of stocks and bonds before death increases with increasing expected lifespans, but annuities, including CPP, address longevity risk in a different way.
When contributors live longer than expected, they gain “mortality credits” from the contributors whose lives ended earlier than expected.
Hedging longevity risk is not something that any individual can accomplish on their own, but it is accomplished efficiently in pooled pension plans such as CPP.
Inflation risk
Risky assets such as stocks and, to a lesser extent, bonds may provide sufficient returns to outpace inflation in the long run, but they do not offer an inflation hedge.
In fact, high inflation tends to have catastrophic effects on the long-term real returns of bonds and cash. The CPP benefit offers inflation indexing. Each year, the benefit for those receiving CPP is increased based on the CPI All-Items Index.
Like longevity risk, inflation risk is extremely difficult for any individual investor to hedge, but CPP is in a much better position to deal with it. CPP is funded by contributions and investment returns.
CPP contributions are increasing with wage growth, which has historically outpaced inflation. CPP Investments, the Crown corporation that invests the funds held by CPP, can strategically invest in long-term, often illiquid assets which would be unsuitable – or unattainable – for most individual investors.
The investment management model employed by CPP Investments is quantifiably successful at hedging its real long-term liabilities.
Sequence of returns risk
Drawing large amounts from a portfolio of assets during periods of low returns can be challenging to recover from, and adjusting living expenses to avoid drawing from the portfolio can be uncomfortable to live with.
The guaranteed income stream from the CPP benefit plays a role in reducing the challenges of sequence of returns risk by providing a baseline level of guaranteed income through all market conditions.
Returns on CPP contributions
As an asset that delivers high return under adverse scenarios (high inflation or a longer-than-expected life), CPP does not need to have a high expected return to be attractive, but its rate of return is a focal point for CPP skeptics.
One way to assess the rate of return on CPP contributions is by looking at the internal rate of return. The IRR is the rate of return that sets the present value of CPP contributions and benefits equal.
In an example with maximum 2025 contributions being made for 39 years starting at age 26, and the expected maximum benefit being received in 2064, the real (inflation-adjusted) IRR at a normal life expectancy at age 65 would be around 2 per cent.
IRRs increase significantly at longer lifespans, particularly when the CPP benefit has been deferred (resulting in an increase). For example, deferring the benefit to age 70 and living to age 95 results in a real IRR of 3.11 per cent. This figure increases at longer lifespans and is stable under high inflation.
For context, a portfolio of 60 per cent stocks and 40 per cent bonds could be reasonably expected to earn a real return of 3.25 per cent, with considerable variability around that expectation.
The IRR on CPP contributions is lower if death occurs prematurely, though a small death benefit and lifetime survivor benefit offer some help in these cases.
A less appreciated aspect of the CPP benefit’s contribution to retirement outcomes is that it allows investors to take more risk with their other financial assets, increasing their expected returns without increasing their chances of financial ruin.
Final thoughts
The CPP benefit is the only inflation-indexed annuity available to most people in Canada. It offers protection against some of the biggest risks that retirees face, and it does so in ways that individual investors cannot accomplish on their own.
We should be happy to have an asset like CPP. Planning to get the most out of it is far more productive than griping about its existence.
Benjamin Felix is a portfolio manager and head of research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charterholder.
